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Funding the Estate Tax – The IRS Wants Cash

 
DISCLAIMER: The purpose of this article is to provide general information which is subject to change and is specific to state law. The author and ReliaQuote are not providing legal advice. If you have a specific legal issue, you should consult a lawyer who is licensed to practice law in your jurisdiction.

If a decedent dies with a taxable estate, the due date for the estate tax return is the date that is nine (9) months from the decedent’s date of death. Even if an extension is filed to extend this deadline, the payment of the estate tax itself must be paid on the initial due date. What this means is that ready or not, the estate is required to create immediate liquidity at least in the amount of estate taxes due. One would think that an estate large enough to require the payment of estate taxes would have sufficient cash or marketable securities which could be sold to fund the payment of the estate tax bill. Very often, however, taxable estates are comprised significantly of real estate, retirement accounts, business interests or other assets that either cannot be liquidated within this time period or cannot economically be liquidated within such time, and the family is left scrambling to gather the funds to pay the estate tax. What happens if the estate is comprised of such inherently illiquid assets and there is very little cash or marketable securities with which to pay Uncle Sam? Will the surviving family members be forced to sell those illiquid assets, potentially at fire-sale prices, to create the necessary liquidity?

Let’s look at an example:

Assume that John and Jane Doe have an estate with a value for estate tax purposes of Four Million Dollars ($4,000,000) and that the estate is comprised of the following assets:

Value of Real Estate: $1,500,000 Value of Interest in Family Business: $1,000,000 Value of Retirement Accounts: $1,500,000 Total $4,000,000

Approximate Estate tax upon the second death: $930,000
(assuming John and Jane utilized both estate tax
exemption amounts)

John and Jane do have life insurance policies, which will generate proceeds that will provide for the well-being of the surviving family members, but those policies are owned by Irrevocable Life Insurance Trusts (ILITs) and will not be subject to estate taxes. (For more information regarding this estate tax planning technique, see the article entitled “How to Make Life Insurance Completely Tax Free.”) While these policies will distribute liquid assets to the family members, John and Jane set the level of their coverage such that, to the extent those proceeds are used to pay estate taxes, the protection they intended for their family will be eroded.

Given the above hypothetical situation, John and Jane’s children will be forced to choose one of two options, neither of which achieves the result John and Jane desired:

Option #1: John and Jane’s children can use the proceeds from their parents’ life insurance policies to pay the estate tax. The problem with this option is that Uncle Sam is now receiving $930,000 of the death benefit John and Jane intended for their children.

Option #2: The children can take distributions from the retirement accounts (which would result in a severe income tax even before the estate tax is paid), sell one of the pieces of family property within the nine-month period (potentially at a fire-sale price), and/or attempt to sell the family business (also potentially at a fire-sale price) to raise the $930,000. Again, the problem with this option is that the children would be forced to rush the distribution/sale of these assets in a considerably unfavorable manner in order to fund the estate tax.

Is there anything else that can be done to ensure the presence of liquid assets available to fund the estate tax so the children will not be faced with choosing between two unfavorable options?

There is a solution and it is found in a life insurance policy, which is taken out solely for the purpose of funding the estate tax. Life insurance, in addition to being a good tool to provide support for loved ones, is a perfect mechanism to provide liquidity for an estate facing an impending estate tax bill. John and Jane Doe did have life insurance coverage, but that coverage was intended to benefit the family, not Uncle Sam. John and Jane could have taken out a separate policy, in addition to the policy earmarked for the family’s benefit, which would provide liquidity for the estate tax upon their deaths. For example, they could have taken out a second-to-die life insurance policy, which would have provided the cash needed to pay the tax.

This solution is much better than the two options discussed above in that (1) the children will still receive the proceeds from the existing term policies and will be able to enjoy those proceeds for the rest of their lives, and (2) the retirement accounts and real estate can be managed by the children as they deem appropriate and will not have to be liquidated to create liquidity.

Be careful! It is important when considering the use of life insurance, to fund the estate tax or for any other reason, to ensure that the proceeds from your policies do not themselves add to the estate tax bill. If a life insurance policy is taken out to provide liquidity, it must be done carefully, to avoid including those proceeds in the survivor’s estate and resulting in an increase the estate tax due.

Please see an estate-planning attorney to determine how life insurance can help fund estate taxes upon your death and how you should structure the life insurance to fit with your overall estate plan.

This article was written by C. Daniel Vaughan, Esq. C. Daniel (Dan) Vaughan is an estate planning attorney with the law firm of Vaughan, Fincher & Sotelo PC in McLean, . He is licensed to practice law in Virginia and other members of his group are licensed to practice in Virginia , Maryland and the District of Columbia . The group is focused on developing and administering comprehensive estate plans tailored to individual needs and circumstances. Dan can be reached at (703) 506-1810 or by e-mail at dvaughan@vfspc.com.